Avoid the Surprise: Assessing and Addressing Preference Risk

There are few things as daunting to a vendor or supplier as its counterparty’s bankruptcy. The likelihood of a significantly discounted recovery for goods and services provided and potential loss of a customer may have long-lasted impacts on profitability.  Even worse, however, is the prospect that payments received in good faith prior to a debtor’s bankruptcy filing may be at risk of recoupment. In this alert, we address the risk that such payments are voidable as preferential transfers. Section 547 of the Bankruptcy Code codifies the power of the debtor to recover payments that were made within the 90 days preceding the filing. Very generally, a debtor (or trustee) may recover any transfer that is (i) made to or for the benefit of a creditor (e.g., a payment or grant of lien), (ii) on account of antecedent debt (i.e., a debt already incurred), (iii) made while the debtor was insolvent, (iv) within the 90 days prior to the petition date (or one year for insiders), and (v) that enables the creditor to receive more that it would have in a liquidation. The parties’ respective intent is irrelevant.

Because the elements of a preference are relatively easy to meet, it is important for creditors to focus on building their defense. While the debtor is required to take a recipient’s likely defenses into account when deciding whether to pursue claims, the standard for that duty remains murky.  Indeed, demands (and later proceedings) are routinely made of all recipients of transfers during the 90-day period. Below we highlight a number of issues to consider when facing a possible preference action.

• Assess the Risk.  Creditors that are regularly transacting with a debtor prior to its filing can assess their maximum exposure by examining the payments (or other transfers) made during the 90 days prior to the filing date (the period does not include the date that the case was commenced). Also, it is good form to review the debtor’s Statement of Financial Affairs (or SOFA) filed during the first few weeks of every bankruptcy case. In the SOFA, the debtor will identify all payments made during the 90-day period according to its books and records. The SOFA is publicly available (and in larger cases easily found and available on the debtor’s claims agent’s website).
• Timing.  Time is not necessarily a creditor’s friend in the case of preferences. The debtor or trustee has two years from the petition date (or one year from the appointment of a trustee) to commence a preference action. Often, actions are not commenced until the end of this limitations period, sometimes giving creditors a false sense of security that they are free from challenge. In certain cases, avoidance actions may also be brought by a trust that is established to pursue claims and make distributions to creditors following confirmation of a debtor’s bankruptcy case.   
• Ordinary Course Defense.  While the elements of a preference claim are relatively easy to establish, creditors can employ numerous defenses to defeat, or limit, a preference action. Chief among them is the “ordinary course of business” defense – transfers that were made in the ordinary course of the parties’ relationship or in the ordinary terms in the industry are immune from avoidance. Courts will typically look to the historical pattern of invoice and payment dates to determine whether payments made during the 90-day period were within the ordinary course dealings established by the parties prior to the period. In order to be best prepared to defend an attack, creditors should perform their own analysis of their payment history with the debtor, both historically and during the 90-day period, to determine the likelihood of challenge and prepare any applicable defenses. There are several ways to determine ordinary course, including whether the payments were received within the historical average, the median or the range of number of days between invoice and payment. Identify any unusual activity during the period that might impair an ordinary course defense. For example, demand notices or threats to take action for non-payment will be harmful. When a defense rests on the terms prevalent in the industry, expert testimony may be required.
• Other Defenses.  Other common defenses include (i) a contemporaneous exchange of new value (g., payment of goods on delivery should not be treated as “antecedent” debt) and (ii) providing subsequent new value (e.g., provision of additional goods after receipt of the preferential payment and for which payment was not received).
• Settlement.  Typically, the debtor or trustee will threaten to pursue preference actions against virtually all recipients of payments during the 90-day period. They may even hire a firm that specializes in pursuing avoidance actions, taking advantage of economies of scale. The relatively low cost to threaten, and then pursue, a claim gives the plaintiff an immediate advantage. Creditors, on the other hand, will be defending only one action and have the burden of establishing a defense. Costs could be high, even to defend a small payment. Plaintiff’s know this and have leverage to achieve a settlement of claims that may be entirely defensible at trial.  An early internal analysis of the parties’ payment history, for example, will best position creditors to engage in negotiations.              

Vendors and suppliers must be vigilant, watching for signs that their counterparty is in distress. Require cash in advance of delivery where feasible. If possible, creditors should take security interest in the goods delivered. Importantly, an early awareness of any preference exposure, and the preparation of any defenses, will best position a creditor to address any later preference demands (and perhaps address risk on a proactive basis in a manner that may eliminate, or reduce, later exposure).